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US Federal Reserve: behind the curve?

The market is under-pricing the risk that the Fed will tighten rates more quickly than expected, says Michael Grady.

The Federal Reserve (Fed) lifted interest rates on March 15 for only the third time since the global financial crisis. Encouraged by headline inflation nearing its two per cent target, stronger growth and conditions in the labour market, the Federal Open Market Committee decided to the raise the target range for the federal funds rate to between 0.75 per cent and one per cent.1

However, the central bank signalled it was in no hurry to quicken the pace of tightening from December’s median projection of three rate rises this year. This may have disappointed some market participants judging by the immediate reaction in the Treasury bond market, with ten-year yields falling to 2.5 per cent at the end of March 15, after peaking at around 2.61 per cent the previous day.2

Like the Fed, the market largely expects three quarter-point rate hikes in 2017. Nevertheless, the new administration’s fiscal stimulus plans, buoyant equity markets and forthcoming European elections are among the risks that may cloud future monetary policy calls. After hiking rates more slowly than anticipated in 2015 and 2016, is the market underestimating the risk that the Fed fails to tighten quickly enough to avert a surge in inflation?

MG: Our view has not changed since the start of the year – we expect three rate hikes in 2017. We had been thinking that the first rate rise in 2017 would be in May or June rather than March.

The first rate rise this year came earlier than expected due to persisting strong US economic data. Positive data surprise indicators are at elevated levels, with strength across the board. By itself, this would probably have been insufficient to justify a March hike. But as global growth indicators have picked up, downside risks from this source have diminished materially as Chinese expansion stabilises and more positive data comes out of Europe and emerging markets.

The signs of strengthening domestic and overseas growth appear to have been enough to shift the mind-set of many Fed officials. Indeed, while the central case is for three hikes this year, risks now seem tilted to more rate rises.

Has the March hike changed the market’s views on the pace of policy tightening?

MG: The probability of a hike shot up early this month on the back of a few speeches from US policymakers. The rates market is pricing in a little less than three hikes in 2017, broadly in line with the Fed’s expectations; the first time in a very long time that the markets concur with the Fed’s ‘dot plot’ charts.

However, next year the markets are only priced for one or two hikes rather than three or four. So, that is where we anticipate seeing more of a repricing of rate expectations, especially as more certainty emerges on any fiscal stimulus package from the Trump administration. Indeed, if we have relatively clear sight on a meaningful stimulus package by mid 2017, we may be in a position where three or more rate hikes are price in for 2018. This may be the catalyst for a sell-off in longer-dated yields, perhaps in the region of 50-75bps.

Is the recent boost to US sentiment driven by the economy more than Trump?

MG: It is difficult to separate out both elements. Financial conditions remain positive for households and companies in terms of equity prices and low borrowing rates by historical standards. Trump seems to have had more of an impact on business rather than consumer sentiment.

Small business surveys jumped dramatically after November’s election and have stayed elevated, with the three monthly National Federation of Independent Business surveys to February among the highest on record.3 Small businesses have been encouraged by anticipated tax cuts and easing of regulatory requirements. For consumers, increased sentiment – the Consumer Confidence Index in February was at its highest since July 20014 – is the result of real income growth over the last year, supported by a strong, strengthening labour market and perhaps an expectation of income tax cuts.

Will real wages continue to grow?

MG: We have seen some moderation in real wage growth as inflation has picked up. Headline inflation is now over two per cent. Remember that inflation was close to zero twelve months ago, aiding real wage growth data. But looking ahead we expect nominal wage growth to continue to rise steadily, with headline inflation actually easing back a little towards the end of the year. That would see real wage growth look somewhat better than it is today.

Can the US economy handle three rate rises this year?

MG: The issue is the appropriate level of rates for the economy and for the Fed to meet its mandate. The Fed continues to run accommodative policy, and the pace of rate hikes is likely to be sufficiently slow that the tightening in domestic financial conditions is modest. Even after the March hike, conditions actually look easier than they did when the central bank raised rates in December given the softening in the dollar and the rise in equity prices.

The bigger question is if the Fed is already behind the curve and the implications of that. I don’t think they are too far behind the curve, as I don’t expect core inflation to rise dramatically above target over the coming year or so. But the reality is that with inflation already around target and the economy close to full employment, it is hard to make the case for policy rates that imply deeply negative real interest rates.

No doubt the pace of tightening will be brought into sharper focus if there is a significant fiscal stimulus delivered towards the end of 2017.

Has the Fed incorporated President Trump’s fiscal stimulus plans in its thinking?

MG: The Fed’s focus in March was on the US economy, and potential fiscal measures were probably at the back of their minds. It is still too early for the Fed to be factoring higher fiscal spend into the interest rate decision.

Trump’s address to Congress on February 28 and the White House’s ‘skinny budget’ on March 16 did not disclose any real details on any potential fiscal stimulus. Indeed, the Republicans’ first priority will be to get their alternative plans to ‘Obamacare’, the American Health Care Act, through the House and Senate. Until there is more clarity on that, I doubt there will be more clarity on the tax initiatives.

It is unlikely any fiscal boost will come through before the back end of this year or into 2018. If some elements of the budget become clear earlier and well-flagged, consumer demand and corporate spending decisions may kick in ahead in anticipation of the change. We are seeing household and corporate sentiment at post crisis highs. Arguably there is already some expectation of additional fiscal spend being built into investment decisions, though the extent to which companies can bring forward such decisions is limited by the availability of credit.

What effect is the stronger dollar having?

MG: Assuming the Fed delivers on three hikes in 2017, the market would probably price in another three hikes in 2018 or six over the next two years, which is more than is priced in currently. If that comes to pass, we would expect the dollar to be well supported over the next twelve months.

When the Fed has raised a strong dollar as a concern, it has usually been on the back of an international story, not an American one, and weaker overseas currencies. This time it would be more clearly the case of interest rate hikes in response to strong domestic growth and a buoyant labour market.

That said, there is a nuance on the dollar story. If the dollar rose by say 10 per cent over the next year, you would see more caution in the pace of rate hikes.

Will the dollar be supported by increasing central bank divergence?

MG: The cyclical upturn in Europe is welcome but not sufficient to warrant any tightening in euro-zone monetary policy this year. Unlike the last few years, the risks are more biased towards the European Central Bank starting to taper (or even hiking) this year, but our central scenario remains for tapering to start in 2018.

In Japan, inflation remains a long way below the Bank of Japan’s target and the central bank seems unlikely to alter its yield curve target or lift rates in the short term.

In this context, the dollar does not look mispriced. However, if the outlook differs from consensus, the direction of expectations drift will indicate where the pressures on the dollar might be later in the year. For the euro we could just as easily see an upside growth or monetary policy surprise as we could see an upside one in the pace of Fed hikes in 2017. So the scope for the dollar to appreciate much more against the euro may be limited. In terms of the yen, the risk of increased policy divergence is supportive of a stronger dollar, with little sign of a material change in the outlook for the Japanese economy in the medium term.

On December 21 the people of Catalonia go to the polls to elect a new regional government. There is a lot riding on the outcome, not just for Spain’s political system, but for the country’s economy and financial markets too.

Important Information

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at March 20, 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

RA17/0396/30062017

Michael Grady

Interim Head of Investment Strategy, Multi-asset & Macro

Main responsibilities

Michael is interim Head of Investment Strategy and is responsible for formulating our ‘House View’ and the risks to that view, as well as overseeing the SIG process for the AIMS funds. Since joining Aviva Investors as Senior Economist and Strategist, Michael has been responsible for monitoring and analysing global macroeconomic, market and policy developments, and plays a key role in our House View and SIG processes.

Experience and qualifications

Prior to joining Aviva Investors, Michael was senior economist at COMAC Capital Llp, a global macro hedge fund, where he was responsible for the fundamental analysis used to inform the investment process. Prior to this, he spent a decade at the Bank of England in a variety of senior roles, latterly as a Senior Manager in the Markets Directorate. He began his career at the Australian Treasury.
Michael holds a BEc (Hons) from Macquarie University, Australia.